Technical Analysis

Before we progress, we would like to point out the two types of financial trading analysis: fundamental analysis and technical analysis. Fundamental analysis will be covered in more detail in the upcoming lesson. This particular lesson is designated for technical analysis. Now that that’s out of the way, let’s get started!

Why You Need to Know Technical Analysis

The answer is straightforward. Knowledge is power. Technical analysis is one of the most crucial investment subjects that any investor or trader needs to learn before making any trade decisions. A wise investor or trader understands that each financial market has its cycles. The key to making abnormal, exceptional profits is all about knowing and following the seasons’ patterns.

Why Technical Analysis?

Technical analysts believe that all necessary information, even data unknown to the public, is reflected in the chart. The price per se reflects all that is known or knowable of a particular financial instrument. They argue that you don’t have to understand what the information is. You need to observe its effect on the price.

How is this possible, you ask?

Let’s assume that a particular investment bank or mutual fund has discovered through its research that a specific stock XYZ is substantially undervalued. The bank or mutual fund will start buying the stock aggressively.

You may not know what it is that they know, or even who “they” are. But if you look at XYZ’s chart, you will see the effect of that buying in the form of a rising price. Even if you don’t know the reason behind the move, you’ll immediately understand that the price rise is trying to tell you something.

So, what exactly is Technical Analysis?

Technical analysis is all about charting data and interpreting charts using technological tools and techniques. It’s the study of directional movement of prices- more specifically, price patterns- to identify favorable trading opportunities. In technical analysis, the only thing that matters is the directional price movement and where it might move in the future. All fundamental value of a financial asset is considered immaterial.

The logical approach for technical analysis is based on two elements. First, is that the price of a particular financial instrument reflects all the knowable information about the asset at any given time and the opinions of all market participants given that information. Second is that all changes in emotion and sentiment are shown in the relative action of price and volume. Therefore, they provide recurring price patterns that give clues to potential future price movements.

Technical analysis does not question why the price has moved, but how. The only concern is whether the present state of the price will be short-lived or will continue. The challenge lies in anticipating the next direction of prices and whether to buy or sell based on the price pattern and other technical indicators.

The topics that are important in basic technical analysis include:

• Charts
• Trends
• Volume
• Moving Averages

Below we take a look at each item and how it related to technical analysis.

Charts

Charts are tools that allow investors and traders to keep track of opportunities and see when it’s time to change strategies. They are appealing to traders and investors as they capture all relevant data and display it logically. They reveal a great deal of how the market got to where it is, supply and demand, investor sentiment, and pent-up price potential. However, they do not predict the future. They merely determine the probability of success in deciding whether to buy, sell, or hold.

This is often done using one of the following types of charts:

• Bar charts
• Candle-stick charts
• Line charts

Each chart offers a different window with which to view price information. Candle-stick charts are focused on particular patterns. Line charts provide a general view, while bar charts offer complete information regarding the high, low, opening, and closing prices of a financial asset.

Perhaps the most popular charts today are candle-stick charts. They visually appeal and convey price information in a quicker, more efficient, and easily understandable manner.

Trends

Prices move in trends. In general, the financial market, including the many financial instruments in it, doesn’t jump up-and-down in an all-together fashion. Instead, they show definite organization and d pattern in their charted course. The movements (trends) may either be up, down, or sideways (horizontal). The primary tool used to identify trends is known as a trend line.

It’s a straight line that connects two or more price points, which extends further to act as a line of support or resistance. They are essential tools in trend identification and confirmation. They identify the direction of the movement of prices to determine if and when the move will change.

Trend lines can be categorized as follows:

• Down Trend-line

A down trend-line connects two or more high prices in a price chart. A sequential decrease in maximum prices characterizes it.

• Up Trend-line

An up-trend-line is a line that connects two or more lows in a price chart. A subsequent increase in minimum prices describes it. 

• Sideway Trend-line

The sideway trend-line signifies stability between supply and demand in the marketplace. Prices in such a market can either break upward or downward. Therefore, it’s vital to establish the top and bottom of the range as it could position the stage for a sharp turn once the sideways trend is broken.

Volume

Volume, coupled with price, is a critical element in technical analysis. Price shows the direction of a security or the market, while volume shows the direction’s intensity. For instance, when prices and volume levels increase, the security is said to be in an uptrend. This happens because bullish traders participate in the market and push the prices up. 

The number of financial assets that change hands within a given period, for instance, reflects the volume of that asset within a day. If there were 100 trades for that particular asset, with each trade involving the exchange of 10,000 shares on average, then the asset’s volume for that day would be a million shares.

Volume is a critical tool for identifying a trend. For instance, a rising volume shows an increased interest on behalf of investors to participate in trades. High volume often accompanies rising prices (but not always). Moreover, the volume is usually high at points where a new direction is about to form (often when the trend is up).

Low volume usually signals investors’ loss of interest, indecision, or disappointment in a security or the marketplace’s prospects. It’s also an indication that there isn’t any new information about a security or the market that can prompt investors to either buy or sell. Low volumes are synonymous with falling prices. At near price bottoms, low volume is a sign that not many sellers are left to put more pressure on the prices.

Moving Averages

A significant problem that traders face when looking at stocks and other financial instruments is handling volatility. Stock prices tend to swing frequently and wildly due to imbalances between supply and demand influenced by current events such as global news, election wars, etc. These frequent up-and-down fluctuations make it challenging to identify running points in a trend. Moving averages are used to “smooth” the prices to highlight the underlying trend.

For instance, if we follow a 100-day moving average line, we would add up the closing prices for the last 100 days and divide by 100. This gives us one data point or an average of that stock’s closing price over the previous 100 days. The moving average can be any length of time; it could be a 50-day moving average, a 10-day moving average, etc. It all relies on how you handle your time horizon.

Once moving averages smoothen out the price, especially of very active moving instruments, a clear picture of that instrument’s general trend becomes visible. The moving average then helps us determine what action to be taken next is. However, do not use moving averages as buying or sell signals. They are merely indicators.